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Lesson 5 Tax 526

1. Briefly explain the reason Congress enacted the marital deduction for married residents of common-law estates.

In the nine community property states of the US, any property acquired during the marriage (other than property inherited or received as a gift) is considered property of both spouses. Therefore, when one spouse dies, half of the deceased property is excluded from the deceased estate because it belongs to the surviving spouse. In order to make estate taxation equitable to spouses living in common-law states, Congress enacted the marital deduction which operates as an equivalent mechanism to the transfer of property between spouses in community property states. The need for the equivalent mechanism was because in community property states, the automatic split of assets between spouses reduced the size of the deceased estate and therefore the taxation of the estate.

1. What are the requirements to qualify for the marital deduction?

In order to be eligible for the marital deduction, property must be a qualifying interest. This means it cannot be a terminable interest. A terminable interest is one that terminates at the death of the surviving spouse1. Since it terminates, it would not be included in the surviving spouse’s estate and since it cannot be included, it would escape taxation. To close this tax evasion loophole, Congress deems terminable interest property to be ineligible for the marital deduction and it is included in the deceased estate.

Other requirements to be eligible to use the marital deduction are basic requirements:

• The decedent and spouse must have been married at the time of the decedent’s death

• The surviving spouse must be a US citizen

• The property must actually transfer to the surviving spouse

• The property would have been included in the decedent’s estate

1. What it the general theory and goal of the terminable-interest rule?

The general theory and goal of the terminable-interest rule (as explained in the previous response) is to prevent the decedent from deducting property from his estate that is transferred to a surviving spouse and would also not be included in the surviving spouse’s estate - therefore avoiding taxation2. Terminable-interests provide for a surbiving spouse, while allowing any remaining interest at death to be transferred to the decedent’s other heirs. This is helpful in situations when the decedent has children from a previous marriage, if the surviving spouse remarries, or when the decedent would like to make sure that his goals are carried out according to his own wishes and not the surviving spouse’s wishes.3

1. What are the advantages and disadvantages of outright marital bequests?

An outright bequest directs the executor to transfer certain property directly to the surviving spouse and gives the spouse the right to use and the discretion to manage the asset according to preference. The downside of this occurs when a surviving spouse has poor money management skills or careless spending habits. By giving the spouse a direct bequest, its less likely that the surviving spouse will contest the decedent’s will and no trustee or court accountings are required. If the surviving spouse has a large estate, the transferred property could potentially increase the taxation of his or her own estate at the time of death. If the spouse does gift or consume the transferred assets before his or her own death, it may be to the detriment of waiting beneficiaries, or to the benefit of a second spouse. If the surviving spouse has creditors, they have access to and may attach liens to the transferred property.

1. What is the general rule and limitations for the charitable deduction?

The general rule for charitable deductions is that it must be included in the gross estate in order to be deductible. The amount of the deduction is unlimited but only the amount actually transferred qualifies. The charitable organization must be qualified. The deduction is denied if the charitable organization is for the benefit of an individual, a political candidate, contingent on a certain event, or in attempt to influence legislation. In the event of a split-interest arrangement, it may be partially deductible. If a charitable interest is a remainder interest trust and someone other than a charity has an intervening interest, like a life estate, no deduction is allowed, unless the remainder interest is a:

• Charitable remainder annuity trust (CRAT)

• Charitable remainder Unitrust (CRUT)

• Pooled-income fund

• Nontrust remainder interest in a farm or personal residence4

1. How may a disclaimer be used to pass property to a charity?

If a beneficiary makes a qualified disclaimer and therefore does not accept the property bequested to him or her, so long as that beneficiary does not retain any rights to the bequest including assignment to another individual, a charitable deduction is allowed for amounts that are actually transferred to a qualified charity.

1. Identify the four general types of partial interests passing to charity that can qualify for the charitable deduction.

• Charitable remainder annuity trust (CRAT) – a trust established with fixed payments to a non-charitable beneficiary in an amount of at least 5% of the initial value and no longer than 20 years, with the remaining amount passing to a qualified charitable organization. No additional funds are allowed to be added to the annuity trust.

• Charitable remainder Unitrust (CRUT) – similar to a CRAT, annual payments are made to a noncharitable beneficiary (not less than 5% of annually valued trust assets) however instead of only payments from income, if insufficient income is earned, payments cannot be made from principal. Surpluses in future years can make up the differences from prior years. The remaining assets will pass to the charitable organization.

• Pooled-income fund – a fund maintained by a charitable organization that contains donations from many donors that still allows a deduction for the funds donated from the decedent’s estate

• Nontrust remainder interest in a farm or personal residence – a farm or a residence is gifted irrevocably to a charitable organization but with retained rights of use by beneficiaries or the donor. These rights are a fixed term or for a life term.

1. What is a charitable gift annuity and what are its advantages?

A charitable gift annuity is basically an annuity purchased by a donor from a charitable organization. The donor makes a donation in exchange for annuity payments from the charity to the person the donor chooses. The tax deduction is available because the value of the cash or property transferred is less than the present value of the annual payments from the charity. The property donated is invested and each payment is comprised of return of capital, capital gain, and ordinary income. The capital gains are unrealized gains and are therefore deferred gains. In summary – the donor gets a charitable deduction, fixed annual payments from the charity (though subject to risk the charity will not have funds available), and no trustee fees or trust agreement are required.

1. Briefly describe the two current types of state death taxes.

Inheritance tax is tax on the beneficiary’s right to receive property from an estate. It’s based on the value of the property transferred. Many states have designated beneficiary groups that determine the amount of exemption that will be afforded to them based on relationship to the decedent. Taxes are either a flat rate or a graduated rate.

State estate tax is similar to federal estate tax and is tax on the right of the decedent to transfer property to beneficiaries. Depending on the state, the exemption amount will differ. In my current residence of NJ, the estate tax exemption increased from $675,000 to $2 million in 2017, and since Jan 1, 2018 NJ estate tax has been completely phased out.5

1. Describe the general rules used to determine which state has the right to tax the following types of property:

1. real estate – Real estate is only taxed in the state where it is situated. Since it is attached to land or is actual land, this is easy to determine.

1. tangible personal property – Tangible personal property is also taxed in the state where it is located, but more specifically, where it was usually kept during the life of the decedent.

1. intangible personal property – Intangible personal property may be taxed in multiple states if contact with the intangible property can be proven to have nexus by a state.

1. Describe the most common circumstances in which intangible property is subject to double or multiple state death taxation.

This happens in cases where intangibles are held in trusts outside of the home state, transferred securities, or when it is unclear which state is the home state of the decedent when the decedent lived in multiple residences. Another scenario would be business related property that was incorporated in a state other than the home state.6 The rule of thumb would be to look at whether or not the property has right to protections offered by the law of that state. If so, then it is likely that the property has sufficient nexus in that state and would be subject to taxation.